On July 27, 2022, U.S. Senators Chuck Schumer (D-NY) and Joe Manchin III (D-WV) introduced the Inflation Reduction Act of 2022 (the “Invoice”) to the FY2022 budget reconciliation bill, a legislative process that requires only 50 votes to pass. The bill includes tax provisions designed to generate revenue to pay for investments in health care, energy and climate change programs and to repay a portion of the federal budget deficit.
The main tax provisions of the bill include:
(i) an extended 5-year holding period for carried interest, (ii) a 15% minimum corporate tax, and (iii) increased funding for IRS and enforcement activities.
Five-year deferred interest holding period
The bill, if passed, would generally make it more difficult for general partners of investment funds to qualify for the preferential capital gain rate of 20% in respect of capital gain allocated under deferred interest agreements increasing the period over which the underlying asset must be held from three to five years. This bill would build on the Tax Cuts and Jobs Act 2017, which first extended the required holding period for interest carried from one year to three years under the Section 1061 of the Code.
Virtually all requirements. Under the bill, to qualify for the preferential long-term capital gains rate, the gain allocated to the holders of carried interests must be realized more than five years after the later of the following dates: (i) the date on which the taxpayer acquired “substantially all” of the applicable interest in the partnership or (ii) the date on which the underlying partnership acquires “substantially all” of the assets held by that partnership from people.
Isn’t it clear how “substantially all” would be determined in relation to an investment fund that deploys capital over a multi-year investment period and uses special purpose vehicles and parallel funds. Therefore, there is uncertainty as to whether the promoter of an investment fund that makes its final investment at the end of a five-year investment period should delay the start of its five-year holding period. (for a total of ten years) in order to benefit from the preferential rate of capital gains.
Extended scope. The bill would expand section 1061, for the first time, to include income from mark-to-market contracts under section 1256, long-term capital gains realized under section 1231 and qualified dividend income. Additionally, any gain realized on the sale of an interest in a partnership, whether recognized or not, would be subject to the new rules in Section 1061.
Affected taxpayers. The extended holding period requirement would only apply to income and gains attributable to portfolio investments held on behalf of third-party investors, such as interests held by private equity funds and hedge funds. Real estate trades or businesses and taxpayers earning less than $400,000 would be subject to a three-year holding period requirement rather than the five-year holding period described above.
Additional tips. If this bill passes, additional guidance would need to be issued to address the new Section 1061 mechanism. The bill directs the Treasury Department to issue regulations preventing the circumvention of holding period requirements by (i ) the use of in-kind distributions of assets with a longer embedded holding period as well as (ii) deferred interest waivers, where a general partner waives the right to receive their deferred interest on an investment currently made in exchange for the right to collect which relates to a subsequent investment with a longer holding period.
15% minimum corporate tax
The most significant tax proposal is an alternative minimum corporate tax of 15% (the “AMT”) on some large companies.
Applicable companies. The AMT would apply to any company (other than an S corporation, regulated investment company, or real estate investment trust) that earns an average of $1 billion in “adjusted financial statement income” (“AFSI”) for three consecutive tax years. A U.S. subsidiary of a foreign-controlled group that passes the $1 billion AFSI test is only subject to AMT if it passes a $100 million AFSI test that examines U.S. members of the group . Once a company meets the $1 billion test, it would remain an applicable company indefinitely, even if its AFSI falls below the $1 billion threshold. The only exception to this rule would require a determination by the Treasury that continued treatment as applicable corporation would not be appropriate.
AMT Calculation. The AMT imposes a 15% corporation tax applied to a company’s adjusted financial statement income, which is generally calculated by taking the net income or loss reflected in a company’s financial statements and making certain adjustments upfront (including adjusting net income or net loss upward to exclude the payment of any federal or foreign taxes). Companies would then reduce this amount by up to 80% by deducting any net operating loss carryforwards in the financial statements. The AMT can be further reduced by certain foreign corporate AMT tax credits.
Increase in IRS Funding and Enforcement
This year, the IRS received an increase in its annual budget for 2023, up to $13.6 billion from $12.6 billion in 2022. The bill provides additional funding of $82 billion for the IRS over the next ten years, with all amounts allocated for specific purposes. . The largest allocation would grant $45 billion to increase tax enforcement, which should lead to higher levels of tax audits and criminal investigations. Other notable allocations include $25 billion for IRS operating expenses, $4.8 billion for business system modernization, $3.2 billion for improved taxpayer services, and $100 billion. million dollars for the Office of Tax Policy to enact new regulations and guidelines.
At this time, it is unclear if the bill will pass or if any significant revisions will be made to its terms. If passed as currently written, the Inflation Reduction Act of 2022 would make significant tax changes that could increase the complexity of tax compliance in the United States and would have a significant impact on large corporations, general partners of investment funds, and the scope and capacity of IRS law enforcement activities.